An investor’s decisions are influenced by many cognitive distortions, systematic errors that arise from the way the brain works. One such distortion is survivorship bias. This can be applied to any sphere, including playing the Aviator betting game and even relationships. Let’s break down how it works and what impact it has on investments.
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What Is Survivorship Bias?
A person often makes a decision based only on the data they know. However, due to ignoring missing information, the decision turns out to be wrong. This is the “survivorship bias.” The way it works can be understood with an example.
The story of Hungarian mathematician Abraham Wald is usually cited as an example. During World War II, he was tasked with improving the defense of bombers. Wald studied those airplanes that came back with breaches. If the mathematician had suggested strengthening the damaged parts, he would have overlooked unobvious information and made a “survivorship bias.”
Wald did the opposite. He assumed that the places with holes didn’t need protection. After all, those bombers were able to return to base. But the most undamaged areas needed to be reinforced. After hitting such areas, the plane was out of commission and couldn’t return, so Wald didn’t see them during the data collection.
Broadly speaking, “survivorship bias” can describe many situations when scientists have received data from a group of “survivors.” Whereas nothing could be learned from the dead ones anymore. This is how cognitive distortion got its name.
Survivorship Bias in Investing
In investing, as in life, various cognitive distortions work the same way. These include the “survivorship bias.” This can include all those situations when an investor takes into account only available information and doesn’t take into account other factors. Let’s look at the main examples when cognitive distortion prevents you from making a sound investment decision.
When Investing in Compound Instruments
When an investor buys a share in a mutual fund, he acquires a portfolio of several instruments at once. Some of the assets may have very good potential and be at their peak of growth. It can be assumed that they will eventually pull the whole portfolio to the upside, but this violates all the rules of diversification.
When choosing composite investment instruments, it’s important to evaluate each individual issuer and the total return of all assets. Moreover, the composition of mutual funds changes regularly, so it’s necessary to look at the strategy of the mutual fund — the result of investments will largely depend on the actions of the fund manager.
When Studying Other People’s Transactions
We are used to hearing about famous investors who, time after time, succeed and get fabulous profits from their deals. However, we rarely look at their failures. But every investor, even the biggest and most famous, has had downfalls. It’s important to analyze not only positive but also negative experiences; it will help avoid mistakes and not repeat failures.
When Investing on the Upswing
When choosing instruments, investors pay attention to the situation at the moment. If security is growing, it’s the right time to invest in it and earn money. However, if you study the rolling yields over several years, you will find that the yield isn’t so high or is negative at all.
Evaluating investments on a short-time horizon is also a survivor’s mistake. The market is cyclical, with ups followed by downs. If you study returns over a long time, you can get a more complete picture of a security and make a more informed decision. It’s also worth remembering the rule “buy on the fall, sell on the rise” — this formula helps many successful investors earn money.
How to Avoid the “Survivorship Bias”?
In order not to fall for this brain trick, it is enough to approach each transaction as carefully as possible.
Don’t make decisions too quickly. Give yourself a few hours to think and analyze. Sometimes it’s useful to take a break to calm emotions and return to rational thinking.
Be skeptical of any information. News is often far from reality, and success stories don’t show failures behind them. You shouldn’t believe 100% in a good outcome; common-sense pessimism can sometimes save you from a lot of risks.
Try to study the full information about the subject of the transaction. Don’t limit yourself to what is on the surface; always study the maximum amount of information necessary for an informed decision.
Don’t copy someone else’s strategy. Always keep in mind your objectives and values and adjust your actions. Otherwise, you risk not reaching your goal.
